(Sep 16, 2003) T030000 Measuring the Distribution of Tax Changes

There are many measures of the distributional effects of tax changes. The most informative measure may be the percentage change in after-tax income. A tax cut that gives everyone the same percentage increase in after-tax income leaves the relative distribution of after-tax income unchanged. A tax cut that increases after-tax income proportionately more for lower- than for higher-income taxpayers will make the tax system more progressive (or less regressive). One that increases after-tax income more for higher-income taxpayers than for lower-income taxpayers will make the tax system less progressive (or more regressive). Note that since the income tax is one of the most progressive taxes in the federal system, an across-the-board income tax cut that increases every tax filer’s after-tax income by the same percentage would tend to make the overall tax system less progressive, because it would collect proportionally less revenue from one of the most progressive sources.

We also report two other measures: the share of the tax cut received, and the size of the tax cut in dollars. Each is useful for certain purposes, but can be misleading. The share of the tax cut received can be misleading because the income tax is highly progressive. High-income taxpayers may garner a large share of an income tax cut, but the tax system could still end up more progressive if their share of the tax cut is much smaller than their share of overall tax liabilities. The tax cut in dollars can be similarly misleading because high-income households have substantially more income than others and pay more tax. Thus, even a progressive tax cut (that is, one that gives a bigger percentage increase in after-tax income to lower-income households than to higher-income households) is often larger in dollar terms for higher-income households than for lower-income households.

An alternative distributional measure that is sometimes used but is extremely misleading is the percentage change in tax liability. Because low-income tax filers pay less tax than high-income taxpayers, a tiny tax cut for low-income people can appear to be a giant reduction in tax liability, even though it does not raise their after-tax income very much. For example, if someone earning $20,000 pays $1 in taxes and someone earning $2,000,000 pays $500,000, legislation that provides a $1 tax cut for the low-income person and a $100,000 tax cut for the high-income person would be shown to cut taxes by 100 percent for the low-income household but "only" 20 percent for the high-income household. In fact, such a tax cut would only increase the after-tax income of the poor person by 0.005 percent while increasing income of the wealthy person by 5 percent. That is, measuring the percentage change in tax liability would make the tax cut look like it was tilted toward low-income household, even though it is 100,000 times larger in dollar terms for the high-income taxpayer, and provides a percent change in after-tax income that is 1,000 times higher for the high-income taxpayer.